Punish the guilty, spare the system

The bribes-for-loans scam is unlikely to have any impact on the Indian financial system as a minuscule portion of banking assets is involved, but senior bankers are a worried lot these days, fearing a witch-hunt that will slow the decision-making process in public sector banks that account for roughly 70% of the industry. The finance ministry has already written to the banking regulator to examine how deep-rooted and wide-spread is the practice of bribing bank officials to raise money and the Reserve Bank of India (RBI), in turn, has sought details from banks on such accounts. Almost all investigating agencies, including the Central Bureau of Investigation, income-tax department, Enforcement Directorate and the Central Vigilance Commission have either already involved themselves in probing various aspects of the banker-broker nexus, or are waiting in the wings to get into action. Indeed, they need to move fast to get to the bottom of the scam, but in the process they should not create a fear psychosis in the banking community. In other words, they should punish the guilty, but spare the system. Otherwise, the decision-making process will be destroyed, and that’s not good news for an economy on a firm growth path.

Typically, small loans of up to Rs5 crore are sanctioned by bank branches while relatively large proposals, say Rs25-30 crore, go through a committee of general managers. A few banks such as Central Bank of India have an independent screening committee, too, to take a look at such proposals. Any loan proposal beyond this amount needs the sanction of the management committee of the board. By and large, the banking system follows this architecture to sanction credit proposals but all banks do not separate the divisions that source credit, appraise a credit proposal and monitor a loan account after the money is disbursed. This is crucial to thwart any external influence—be it through a bribe offered by an intermediary, or phone calls by a politician. Then there should be an overall risk management cell to look into credit, market and operational risks. Indeed, some banks follow this system, but at an informal level. So, two general managers heading credit origination and credit appraisals are often found discussing certain corporate accounts over a meal at the executive lunch room of the headquarters and inadvertently ending up trading information that influences the decision-making process. There should be a Chinese wall between such divisions.

Here are a few suggestions to avoid such scams in the future and ensure that even if stray incidents of fraud do happen, there is no impact on the system.

At the outset, let every bank conduct a forensic audit of their loan and investment books (I mean investments in corporate bonds and not government securities). Forensic means “suitable for use in a court of law”. A forensic auditor applies accounting methods to track and collect forensic evidence of embezzlement and fraud. Such an audit distinguishes between a genuine commercial decision going wrong and a decision influenced by other considerations. I am told some smart bankers do conduct such audits when they take over as CEOs of banks where they had not worked before.

While the impact of the scam on the system is negligible, banks need to sensitize themselves to their exposure to the real estate sector as many feel that there’s a bubble waiting to burst. Builders typically take bank loans for housing projects and even before a particular project takes off, they use the money to buy another piece of land. Homebuyers’ money is used to pay off the bank loan and the builders again go for another bank loan for another project and the money is diverted to buy another piece of land. This cycle continues on the premise that land is an exhaustible resource and its price can only go up. If land prices crash, the cycle will come to an end and banks will be saddled with bad assets. Going by RBI data, Indian banks’ overall exposure to the real estate sector was Rs5.8 trillion in March 2010—about 17% of their loan book. Roughly one-fourth of new private banks’ loan assets are concentrated in this sector.

If the bubble bursts, there will be a systemic problem. So banks need to take measures to protect their balance sheets. What can they do? First, they need to closely monitor the end-use of funds and stop giving loans to builders for buying land. Second, for every exposure to the real estate sector they must follow the escrow route for debt repayment. Escrow generally refers to money held by a third party on behalf of transacting parties.

In other words, banks must have direct access to the funds that a real estate developer raises through sale of properties. Finally, banks must cap their exposure to this sector at a reasonable level, say 10% of their loan portfolio. At present, except for stock market-related exposure, the banking regulator has no norms for sectoral caps, but banks should do this on their own as a prudent measure.

Another critical area to keep an eye on could be multiple lending to a borrower. Under consortium financing, banks and financial institutions fund a single borrower with common appraisal and documentation, collective supervision and follow-up exercises, but in multiple banking, different banks meet fund and non-fund requirements of a single borrower without a common arrangement among the lenders. In multiple banking, every bank takes an isolated view and no lender has a clear idea about a borrower’s overall exposure to the system and ability to repay loans and offer collateral. If the banks want to play safe and stop misuse of funds by real estate promoters, they need to take a closer look at multiple banking and plug the loopholes immediately.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai.